Technical Analysis: How to Use Volume in our Covered Call Decisions

When learning how to trade options volume must always be factored in. Volume is the number of shares or contracts that trade over a specific period of time, usually one day. On a chart, volume is represented as a histogram (vertical bars) overlaid on or below the price chart. This indicator is an essential part of every technical formation as a price pattern will typically have a volume pattern attached to it. In other words, we use it to confirm trends and chart patterns. If a stock is truly in an uptrend, we would expect the volume to also be in a similar pattern. This will increase the chances of the trend continuing. Any price movement up or down with relatively high volume is seen as stronger and more reliable than a similar move on weak volume. The same guideline holds for changes in the MACD and stochastic oscillators. If we see positive or negative signals in these indicators, they are more significant on high volume and less so on low volume.

Some chartists will draw a trendline on volume and compare it to the trends of price and other technical indicators. If they are not moving in the same direction, we have a negative volume divergence. For example, if price is rising and volume is declining, there could be a trend reversal on the horizon. On the other hand, if price is declining and volume is accelerating, this negative trend is confirmed and a sell signal is more meaningful. Such an example can be found in the chart below:

The green arrow shows a severe price reversal with volume confirmation (green circle) as the volume bars are much higher than during consolidation.

Technicians who look for specific chart patterns such as triangles, flags and head and shoulders can also utilize volume patterns to confirm the accuracy of these patterns. Another important concept in technical analysis is that volume precedes price. If volume is weakening during an uptrend, it is oftentimes a signal that the trend is about to reverse.

Putting it all together with FFIV:

At the start of the March contracts I bought FFIV @ $125.56. Although the chart pattern was still bullish the confirming technicals were turning bearish. In addition, volume was declining indicating a possible trend reversal. In situations like this I will oftentimes write ITM strikes and allow the option buyer to “pay for” an insurance policy in case the price begins to trend down. I sold the March $120s for $8.62 for a 2.6%, 1-month return with downside protection OF THAT PROFIT of 4.4%. On March 1st the $120 call was trading @ parity (all intrinsic value) as the stock approached $128 so I closed my total covered call position and used the cash to open a new position with a different stock. As it turned out, I didn’t need the downside protection. But the decision I made initially was based on sound fundamental, technical and common sense principles and I still found a way to enhance my already maximized returns. Here is the chart of FFIV as of March 2nd:

FFIV as of 3-2-12

Conclusion:

Volume is an essential technical analysis tool that will verify the significance of a price pattern or technical analysis indicator confirmation or divergence. It can also be predictive of upcoming changes in chart patterns. We use volume to corroborate buy/sell signals. A positive or negative signal on high volume is much more significant than one on low volume. Volume surges (1.5 x normal volume) are especially significant.

The Elite Calculator:

We have made a minor change to how we calculator short-term percentage returns in the “unwind now” tab of the expanded version of the Ellman Calculator. Previously we deducted the option premium from our cost basis as would be done for tax purposes when a position is closed. This approach is not intuitive to many of our members including me. Although the resulting change in miniscule we feel that a case can be made for either approach so we now opt for the one that makes the most mathematical sense. In the example cited in the user guide the % return will change from a 2-week return of 1.8% to 1.74%. Our premium members can access this enhanced version of the Elite Calculator in the “resources/downloads” section of your premium site (“Elite Calculator 2012”). We are also working on updating the Schedule D to reflect the new tax laws. I will send out an email to our premium members and post on this blog when those enhancements have been completed and available to you.

Market tone:

This week’s reports reflected a stable’and slowly growing economy:

The Conference Board’s index of consumer confidence beat expectations (63), rising more than 9 points to 70.8 in February

Durable goods orders dropped 4.0% in January more than anticipated (-1%)

Annualized growth in 4th quarter GDP was revised upward to 3.0% from the advanced estimate of 2.8%

The Federal Reserve’s Beige Book showed improving economic conditions between January and early February with manufacturing a standout in all 12 districts

Personal income increased by 0.3% in January, less than expected (0.4%)

Consumer spending in January was up 0.2% but less than the 0.4% predicted

The ISM gauge for manufacturing activity read 52.4 showing continued expansion but less than anticipated

For the week, the S&P 500 was up 0.3% for a year-to-date return of 9.7% including dividends.

The technicals of the S&P 500 and the CBOE Volatility Index (VIX) continue to impress:

S&P 500 and VIX as of 3-2-12

Despite a great start to 2012 and a 25% increase since October 3rd, 2011 investment dollars continue to remain on the sidelines and even shift out of stocks into bonds. To me this is a residual psychological effect that 2008 had on retail investors. Who could blame them? According to the Investment Company Institute there was an outflow of $218 million from stock funds in January and an inflow of $27 billion into bond funds in the same month. With interest rates requiring a magnifying glass to detect, the fear factor remains a key reason why this market hasn’t been even stronger. When the real estate market strengthens and unemployment improves at a quicker pace we could see a full blown bull market. In the interim, we must remain cautious as global and political events can impact our investments despite the good news.

Summary:

IBD: Confirmed uptrend

BCI: Moderately bullish but still selling an equal number of OTM and ITM strikes. I want to see real estate and unemployment make significant strides before favoring OTM strikes and take a much more bullish stance.

About Alan Ellman

Alan Ellman loves options trading so much he has written four top selling books on the topic of selling covered calls, one about put-selling and a sixth book about long-term investing. Alan is a national speaker for The Money Show, The Stock Traders Expo and the American Association of Individual Investors. He also writes financial columns for both US and International publications along with his own award-winning blog.. He is a retired dentist, a personal fitness trainer, successful real estate investor, but he is known mostly for his practical and successful stock option strategies. Google +

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Now I’ve made a lot of money with this stock over the years and I tend to be more bullish with my trades when it comes to FFIV. However, I am currently selling about half ITM strikes due to my overall market assessment and decided that this would be best used as an ITM candidate due to the mixed technicals. Had I been more bullish it would have worked out even better (as of today!) but I want to show the thought process and then how to manage from there.

2- Calculations:

When the option was initially sold for $8.62 there was $5.56 IV and $3.06 TV. Using the $5.06 to “buy down” the cost of the stock to $120, my initial profit was $3.06/$120 = 2.55%, 1-month return with 4.4% protection of that profit. This combination return with protection was acceptable to me and met my 2% – 4% monthly goal. This return was guaranteed as long as the stock did not decline below $120 and could not be increased not matter how high the price rose.

3- Buying back the option: The increase in share price does not dictate the sale of the option to close although it is related. It is the option premium approaching parity or all IV that does. When the stock was trading @ $128 and the $120 call was trading @ $8.10, I unwound my position paying $0.10 in time value. All I had to do was generate a higher return than .08% to make this a profitable deal. The cash left to re-invest is $12,000 per contract.

My total 1-month return for this cash will probably be between 3-4% even with selling another ITM strike. I respect the fact that investors with a higher risk tolerance than I have may have opted for OTM strikes and there’s nothing wrong with that as long as the decision was based on a firm understanding of all factors.

(Click on the chart to enlarge and use the back arrow to return to this blog).

According to the running list FFIV reports earnings on April 20th so it won’t be eligible for the April options. Is this another reason to sell in the money strike prices since you will sell the stock anyway after the contract expires? I’m pretty sure I read this in one of your past blogs. Thank you.

This is an astute observation on your part. If I plan to sell the underlying in the next contract month due to an earnings report I am more likely to sell an ITM strike. I want to stress though that if the market is strongly bullish and the chart technicals are positive and confirming I may still opt for an OTM strike.

With only 2 weeks remaining in the March contracts there are still some good choices. Check out SWI. Current price is 38.50. The March 37.50 sells for 1.85. That’s a 2.3% two week return with 2.6% protection. That bad for two weeks.

1- Those on our mailing list normally receive a mailing on Sunday mornings but didn’t yet today. I’m being told that the professional mailing service we use is undergoing “unscheduled maintenance” (sounds like their having a bad day!). Once this issue is resolved you will receive the email now and going forward.

2- I have experienced an unusual number of email inquiries both from members and clubs throughout the country. This has put me slightly behind in my responses to our members. As always, I will respond to all emails and should catch up in the next few days.

3- Our Weekly Stock Screen and Watch List is currently being formulated and will be uploaded later this evening. We’ll keep you informed and all premium members will receive a direct email when available.

“I like to see an OI of at least 100 contracts and/or a reasonable bid-ask spread ($0.30 or less)”. For the option I mentioned in comment #3 for SWI the open interest is 871 and the bid-ask spread is 1.85 – 1.95.

Hi Alan, This type of detailed example with entry and exit points along with chart and your thought processes are quite useful. Please do more of these. It is clear from your comments that you track the total position (option + stock) in the market on a daily basis. For every day, there is a choice to 1) hold the position 2) buy back the option and take a different option position 3) buy back and sell the stock. And possibly a fourth which I’ve heard you infrequently mention, buy back the option, keep the stock. Each of these have a different reasoning behind them which is key to successful CC writing. You help with getting better at this reasoning is useful. Warren

I do check my portfolio daily but it usually it takes a few minutes unless it is just before or after expiration Friday. Lately, we have been discussing the “mid-contract unwind” exit strategy which has one important determining factor; that is, the option premium trading near “parity”.

As far as the other exit strategy considerations I have included in my books and DVDs some guidelines. Here’s an example and quote from pages 257-258 of “Encyclopedia….”

“We lean towards implementing a rolling down strategy when the market tone and technicals are mixed to negative. I would also be more inclined to use this strategy later, rather than earlier, in the contract period (late week 2 and week 3, rather than week 1)”

These guidelines are found in “Exit Strategies….” as well.

I appreciate your suggestion and will make every effort to include this information when I use real life examples.

Generally yes to both with the following caveat: Option exchanges will stay open a few extra minutes at the end of the day to 4:02 PM EST with the exception of expiration Friday when the option exchanges close precisely @ 4PM EST.

A market maker being interviewed on a financial program was defending high frequency trading saying that it benefits retail investors. Does anyone see how this benefits anyone but those who have the cash and access to this elite form of trading?

For members unfamiliar with this type of trade execution, high frequency trading (HFT) is an automatic trading platform where powerful computers use complex algorithms to transact a large number of orders at high speeds without human input (the computers make all the decsions). Here are the pros and cons:

CONS:

1- React more quickly to gain an advantage over retail investors like us
2- Many located near or in exchanges and therefore obtain information faster
3- Little or no human “reasoning” during crisis situations (remember the market dropping 900 points in 10 minutes?)
4- Cost prohibitive for retail investors

A case can be made for both sides but I can tell you that the SEC is carefully monitoring the situation particularly a problem you will be reading about relating to the high number of trade cancellations caused by HFT.

I was recently shocked to learn that high frequency traders have an order cancellation rate (Tabb Group) of over 95%. TRhe cancellation rate for retail investors is between 10% – 20%. According to SEC Chairman Mary Schapiro a large portion of equities trading has little to do with “the fundamentals of the company that’s being traded.” She said it had more to do with “the miniscule aberrational price move” that computer-assisted traders with direct connections to the exchange can “jump on” in fractions of a second. Hence trades are constantly being entered and cancelled until the best deal is executed. The SEC is actually considering charging a fee for these cancellations but is also concerned about its potential impact on market liquidity.

If the trade of a stock is suspended through Expiration Friday, how would this affect the rights and obligations of Options sellers and buyers?

In particular, will the stock of a Call Options sellers be automatically delivered for the ITM situation? Can the Put Options buyers exercise their rights for stock delivery? Will the cash be released in a Cash Secured Put position after Expiration Friday?

1- The exercise of an ITM call option will depend on two factors. First, the instructions that the call holder has given to his broker. He may not want to exercise an ITM strike for a halted stock. Second, has the stock been removed from the “exercise by exception ” program. This is where the clearing house will automatically exercise ITM calls even if it in the money by only $0.01. Depending on the day that trading is halted will dicate whether the option remains part of the program. It is determined on a case-by-case basis. (I BELIEVE it is removed from the program if trading is halted prior to Wednesday but I’m not positive).

Our stock market is at the mercy of a tug of war going on between fears of a failed Greek debt swap and an improving US economy. On Tuesday the former shook the market and our portfolios took unrealized hits. Wednesday our economy took charge with the ADP employment report coming in at 216,000 jobs added above the 203,000 estimated and the 173,000 from January. Thursday morning, as I write this post, the futures look strong. Market pschology(fear and greed) will always play a role in our stock market but should never be a factor in our Blue Collar decisions.

I bought VCLK @ 19.43 and sold the March 20 for a nice 4% return. Today the stock is @ 20.40 and if I roll to the April 20 the return is under 2%. Can I expect a better return if I roll closer to expiration? Thanks for your help.

More likely than not, your return WILL be greater as expiration Friday approaches. The time value of the near-term contract will decay at a greater rate than that of the April contract. Of course, much will depend on the implied volatility of the option later next week.

After a disappointing 3/11 earnings report this company has reported three consecutive strong reports. In addition, analysts are projecting earnings growth of over 50% for both 2012 and 2013 while its industry peers have projected earnings growth of 7% and 25% for the next two years. Our premium report shows an industry rank of “A” anda beta of 1.41. See the chart below for earnings surprises (click on chart to enlarge and use the back arrow to return to this blog).

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